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Interest Rates Plunge-Refinance Now
by Michael W. Licamele III
W henever interest rates decrease, as they have by nearly one percent over the past sixty days leading into the Fall of 1997, homeowners wonder whether or not they should refinance their existing home mortgage. Homeowners may benefit from analyzing their current mortgage to determine if a change would improve their financial position at this time.
Refinancing is not beneficial for homeowners who assumed a 30 year fixed rate mortgage at record lows of 7% or below back in 1993 and plan to stay in their home for a long period of time. However, if a homeowner fits into one of the categories listed below, they will most likely find that refinancing their mortgage can save them thousands of dollars over the term of the loan.
The old rule of thumb for refinancing stated that in order to be worth while, the new interest rate must be at least 2% lower than the old interest rate. With changes in the market over the past five years, the old rules of refinancing are now defunct.
Today, as little as a 1/2% interest rate decrease through refinancing can save thousands of dollars if executed properly and in accordance with specific financing needs. A variety of loan terms, no-point rate options and lower closing cost loans have greatly decreased the rate difference needed to make refinancing profitable.
While many consumers spend substantial amounts of time trying to make their savings and investments earn more for them, few consumers really take the time to see how much they can decrease their debt payments. Since a mortgage is usually the largest debt a consumer has, it pays to concentrate most on reducing that payment first.
Many consumers are discouraged from even considering a refinance due to old myths. One myth is that one can not refinance right after purchasing a home. As long as the loan does not have a prepayment penalty, one can refinance a loan at any time. So if a homeowner is stuck with a high interest rate loan of 8.5% or higher right now, he or she can decrease their rate immediately through a refinance.
Reasons to Refinance a Mortgage
There are five major reasons to consider refinancing an existing mortgage:
1) Decrease monthly payments from a higher fixed rate to a lower fixed rate. This is the simplest type of refinance. If the rate is 8.5% now and a homeowner switches to a 7.5% rate, he or she will save 1% on the mortgage less the costs of refinancing. On a $200,000 mortgage, for example, the savings will be over $50,000 over 30 years by reducing the interest rate by just 1%. That return is better than any mutual fund or stock market investment.
2) Maximize short term cash flow with lower payments or a longer term. Many homeowners find that cash flow is tight after moving into a new home. Something always needs to be fixed or replaced. If a homeowner needs extra cash every month right away, switching to an adjustable rate program where the rate is fixed for the next three to ten years could give the breathing room needed for a definite period of time. Similarly, for those who are in a 15 or 20 year term loan, switching to a 30 year term can also increase monthly cash flow.
3) Switch to a fixed rate program to eliminate payment changes of adjustable rate mortgages (ARMs). Homeowners with one year ARMs that started at 6% or lower in will see their rates rise to about 8.25% this year. Using programs that hold rates steady for three, five or seven years, one can refinance now into a rate between 6.50% and 7.50%. Not only does that bring immediate savings, but it protects against an even higher rise in their one year adjustable rate loan next year.
4) Withdraw funds from the equity in a home. If a homeowner needs cash for home improvements, college education or to consolidate debts, he or she may be able to refinance 75% to 80% of the current value of the home if it has been owned for one year or more.
Pushing for Shorter Loan Terms
Probably the best incentive to refinance is found by refinancing into a shorter term loan while keeping the loan payment relatively stable. A borrower who has a $200,000 loan with a 30 year fixed rate at 8.25% pays $1,503 per month and will repay $540,943 including the principal borrowed. A borrower who has had this loan for five years would still have $450,600 in payments to go. Refinancing into another 30 year fixed rate at 7.25% will lower the monthly payment to $1,365 (saving $138 per month), but the original 30 year term will extend to 35 years (five years with the original first mortgage and thirty with the new refinance loan) and the borrower will actually end up repaying $492,000 under just the new loan. The bottom line is that under this scenario a borrower saves $138 per month, but ends up about the same amount after 30 years as if no refinance had taken place.
A smarter long term strategy would be to take out a 20 year loan with payments of $1,580 per month, because even though it will be $77 per month more than the old payment at 8.25%, the borrower will only have to make $379,000 in payments over 20 years. Thus, by paying an additional $77 per month which is $18,480 over 20 years, and by lowering the interest rate to 7.25%, the borrower can save over $110,000 in total mortgage payments.
Strategies for the Sophisticated Borrower
Borrowers who currently have mortgage insurance on their loan because they purchased with less than a 20% down payment may be able to eliminate mortgage insurance by refinancing. One of the most popular new loan products today is the "80-10-10" program. Under this loan plan, (see article on page 13), borrowers obtain a first mortgage for 80% of the value of their home and a second mortgage for 10% of the home's appraised value. By splitting the loan into two separate loans, the first mortgage will not require mortgage insurance and the borrower can save the monthly premium payment.
Another benefit of the 80-10-10 program is that if a borrower has a jumbo loan (defined as a loan greater than $214,600 for a single family home) but can decrease the first mortgage loan to below $214,600 with the 80-10-10 program, then the borrower can obtain lower rates that are available with conventional mortgage loans below $214,600.
Refinancing Costs Lower Than Ever
The costs of refinancing have decreased greatly in the past several years. With no-point loan options, for example, borrowers can save thousands of dollars up front (one point is equal to one percent of the loan amount). Also, closing costs can usually be included in the new mortgage loan amount so that no cash is required to execute a refinance. Deciding whether to refinance usually involves totaling the costs of refinancing and subtracting those expenses from the total savings expected. It is also important to determine how many months it will take to pay back the costs of refinancing from the savings that will accrue.
For example, if a refinance is reducing the rate on a $150,000 loan from 8% to 7% with no points, the savings will be approximately $107 per month and closing costs will be about $1,600. If the home is kept for at least the next five years, the borrower will save $4,820 over that time period (60 months x $107 less $1,600 for costs). Over ten years the savings would be $11,240, and over 30 years would reach $36,920 It will take 15 months to break even on the transaction, so as long as the homeowner does not move before then they will come out ahead.
For those borrowers looking for short-term savings, the no-points/no closing costs option may be for them. For a slight premium on the interest rate, one can obtain a loan with no points and no closing costs. For example, when a borrower has a current rate of 9% rate and 0-point rates are at 8%, he or she can have all closing costs paid for if by taking an interest rate of 8.25%. While this plan reduces total savings over the long-term, one can obtain immediate savings with no cash outlays.
Would Refinancing Be Worthwhile?
There are five main factors to analyze when determining the costs and benefits of refinancing: 1) What will be the difference between the old rate and the new rate? 2) What are the total costs associated with the refinance transaction? 3) How closely is the loan term matched with the expected holding period of the loan? 4) How comfortable are is the homeowner with possible payment changes over the life of the mortgage loan? and 5) Is a first mortgage structure sufficient or should a home equity line be added?
The savings that can be obtained from refinancing depend directly on the answers to the above five questions. It is best to answer these questions with the help of an experienced mortgage professional.